Assigning fixed reserve to the components of a Reserve Study is done as human intervention of the standard distribution of reserves. Usually reserve are distributed to components starting with the earliest replacements and working on down through the later. The amount of distribution is the fully funded value of the components; the component cost minus the straight line depredated value of the component. The formula in its simplest form is:

The state where fixed reserves is often use is Florida. That as a result of the way common property reserve laws are written. It seems to stem from these sections:

FL Condo Law; Chapter 718.112 Bylaws.—

(f)?Annual budget.—

3.?Reserve funds and any interest accruing thereon shall remain in the reserve account or accounts, and may be used only for authorized reserve expenditures unless their use for other purposes is approved in advance by a majority vote at a duly called meeting of the association.

2.?In addition to annual operating expenses, the budget must include reserve accounts for capital expenditures and deferred maintenance. These accounts must include, but are not limited to, roof replacement, building painting, and pavement resurfacing, regardless of the amount of deferred maintenance expense or replacement cost, and for any other item that has a deferred maintenance expense or replacement cost that exceeds $10,000. The amount to be reserved must be computed using a formula based upon estimated remaining useful life and estimated replacement cost or deferred maintenance expense of each reserve item. The association may adjust replacement reserve assessments annually to take into account any changes in estimates or extension of the useful life of a reserve item caused by deferred maintenance.

What often gets done is funds are allocated arbitrarily as the association ages and from (f)3 corrections to the distribution of funds cannot be done, at least, without a member vote. If the provision in the latter part of (f)2 were followed, funds would get allocated in an suitable way and corrected without a vote. The simplest way to conform is to apply the straight line accounting method. And that is appropriate according to:

FL Condo Law; Chapter 718.111 The association.—

(13) FINANCIAL REPORTING

...The rules must include, but not be limited to, standards for presenting a summary of association reserves, including a good faith estimate disclosing the annual amount of reserve funds that would be necessary for the association to fully fund reserves for each reserve item based on the straight-line accounting method.

Fixed reserves would never have to be used to affect the study. It would eliminate skews in the distribution that lead to unrealistic budgeting. I've seen many times where one set of components were badly over funded leaving no money for earlier pending expenses because of fixed reserves.

There is also a CAI publication: 'Reserve Funds: How and Why community associations invest assets'.

From there I cannot find a reasonable explanation for choosing a funding strategy other than to say it is about risk. As we will see, the level of funding is also about value. The community members should understand the implications of choosing a model that maintains a balance of less than 100% of fully funded.

There really are only two funding methods. The Component Funding Method, also called Straight Line. And some other target of funding level most commonly called Cash Flow or Pooled. The 'other' category can be broken down into many different so called goals like baseline, threshold and statutory. But in any case, it amounts to specifying a target of ending balances through the projection, and adjusting the contributions to reserves to attain that target. When the Cash Flow method is used it is typical to maintain a level of funding of something less than the Component Method levels of funding, or, being fully funded. The Component method tends to keep the level of deposit balances well above a minimal requirement to 'just pay the bills', other methods are chosen so as to reduce the required contributions for the members of the association. But this reduced contribution is only temporary.

Under the Generally Accepted Accounting Principles(GAAP), straight line is a method of depreciated funding. The depreciation progresses at a constant rate, hence the name straight line. Common property reserves are about scheduled replacements, so there is no good reason to use any other depreciation method. The rational is that cash is accumulated from the work of an asset through its expected life so that accumulated cash can be used to replace the asset. Of course this should sound like what happens in a reserve study. The valuation of a company is the cash on hand plus the depreciated, or book, value of assets. The same applies to the common property of a home owners association. The Component Funding method maintains the full value of the property by considering the future replacement cost of each component and setting a contribution that reflects a balance against the depreciated value of each component.

For clarity, the following examples are done without inflation, interest income, or contingency. Take a $1,000 liability every ten years. In ten years we would need to have $1,000 collected for that liability, $100 per year. Using a Component, or Baseline Method, the required contribution will be identical, both models produce the same result. Here is the projection with one component.

Component and Baseline Funding Models

As you can see the ending of 2019 is the same amount as the expenditure in 2020. Even though we have essentially run available funds to zero, (The 2020 contribution is not considered available, it will be applied to the next liability), we are 100% of fully funded.

Now with two ten year components five years out of step. The Component model and the Baseline model come up with different results. The Component Funding Method sets the required contribution to keep the balance at 100% of fully funded. The goal of the Baseline Method is to drive the ending balance to the value of the next year's expense. The available funds are driven to zero.

Component Funding Model

Baseline Funding Model

The essential feature of the Baseline Method is that funds are borrowed from future liabilities in the first five years. After that, the Baseline contributions must return to the same level as required by the Component Funding Method. This because the real future liability remains the same. The value of the common property, with reserves, has been diminished by $500. The community members have redirected funds to themselves rather than funding the depreciated value of the study components.

In an ideal world the developer would hand the property over with 100% funding and the new members would maintain that level of funding. If they decide to fund at anything less, they will only be able to do so until baseline level of the study is reached. At that point the contribution will have to return to funding levels that would have been seen as if the Component Method were used. After the point of hitting Baseline Funding, any new home owner will have missed out on the appropriation of these funds by the developer and/or the original home owners.

There is nothing wrong with funding at less than 100% of fully funded, so long as all parties involved understand the real implication. With the above study as an example; a new home owner who would buy property as of 2015 should understand that the real value of the common property and reserves are 75% of the fully funded value. All parties with a vested interest should understand the meaning of real value, that the property is depreciating.

Risk, or contingency, is about the level of funding balances compared to liabilities. That essentially has nothing to do with 'what model'. Cash flow can be driven from Baseline to Component so there really is no difference in models other than a level of funding. Also, the level of ending balances compared to fully funded, (Percent), can be very misleading. This can be seen in the Baseline model above. From 2015 forward it is actually consistently delinquent, compared to the Component Funding Method, by $500, or 25% of the total maintained value of the common properly. The real value of a property is the depreciated value of the property plus the reserves accumulated. The Component Funding Method maintains a real value of $2000 while the Baseline Method maintains a real value of $1500.

This feature is optional. Most studies are done with a single checking or money market account that may acrue interest on deposit. In that case you would just use the direct entry 'Begining Balance', 'Interest Income Rate, and 'Income Tax Rate'. The tax rate is on interest income.

~~~~~~~~~~~

There will be times that the reserves will be kept in multiple accounts. You would have a checking/money market account and may keep excess funds in more than this first account. For instance, you may know you will not need some given amount of money for a time and have it placed in a certificate of deposit to gain more income from interest. Pushing the 'Beginning Balance' button will bring up a multi account system.

Here are the rules thus far.

The first account entry is the primary checking account. It is fixed in first place and does not expire for the duration of the study.

The rest of the accounts can be set to expire when you would like and put in any order. As long as they do not expire and there are sufficient funds for the reserve expenditures, they will stay in place. If in any future year there are not sufficient funds for expenses, they will be withdrawn from the accounts in the order they are listed. If the account is of type CH(checking), SAV (savings), or MM(money market), the assumption will be that money can be taken as needed. i.e., only the amount required will be withdrawn. If the account is CD(certificate of deposit), it will be assumed that it is contractual that the whole amount be withdrawn and that will be put into the primary checking. With the projection showing in the math view there is an option to copy the account schedule to your clipboard. This can be pasted into word or any rich text document in the report. It could also be pasted into the summary text if you would like.

If there is a penalty for breaking a CD you would probably want to create a component with a one time replacement to show this expenditure. We do not attempt to show this information automatically as it probably would not be the way you would want do it.

The rework of this feature was finished on Dec 1, 2011. The infrastructure is now in place to extend this as the need arises.

Thanks, Dan.

~~

There will be times that the reserves will be kept in multiple accounts. You would have a checking/money market account and may keep excess funds in more than this first account. For instance, you may know you will not need some given amount of money for a time and have it placed in a certificate of deposit to gain more income from interest. Pushing the 'Beginning Balance' button will bring up a multi account system.

<photo>

Here are the rules thus far.

The first account entry is the primary checking account. It is fixed in first place and does not expire for the duration of the study.

The rest of the accounts can be set to expire when you would like and put in any order. As long as they do not expire and there are sufficient funds for the reserve expenditures, they will stay in place. If in any future year there are not sufficient funds for expenses, they will be withdrawn from the accounts in the order they are listed. If the account is of type CH(checking), SAV (savings), or MM(money market), the assumption will be that money can be taken as needed. i.e., only the amount required will be withdrawn. If the account is CD(certificate of deposit), it will be assumed that it is contractual that the whole amount be withdrawn and that will be put into the primary checking. With the projection showing in the math view there is an option to copy the account schedule to your clipboard. This can be pasted into word or any rich text document in the report. It could also be pasted into the summary text if you would like.

If there is a penalty for breaking a CD you would probably want to create a component with a one time replacement to show this expenditure. We do not attempt to show this information automatically as it probably would not be the way you would want do it.

The rework of this feature was finished on Dec 1, 2011. The infrastructure is now in place to extend this as the need arises.

Of course, a reserve study is about planning to have sufficient funds for future ‘events’. A discussion about philosophies of the study will be left for another time. Most studies are done by pooling all future expenses. Distribution of funds on a per component bases is often neglected because it really does not lend to what the association considers adequately funded..

But funding at the component level is often presented in a study even when some other funding philosophy is adopted. This is an explanation of component funding.

Consider a simple case where you plan to make a purchase in the future. You have some fraction of the funds needed in an account today so will have to make regular contributions to this account to meet the future purchase. If the account is not interest bearing the contributions are pretty simple to calculate. But most accounts are interest bearing and this interest can have a considerable effect on the needed contribution. In Reserve Analyst we use a financial math engine that calculates the numbers. You can find a description of the math by searching annuity and annuity due on the web.

Example.

Future expense: $10,000

Present Deposit: $5,000

Time to expense: 5 years

Interest on deposit: 3%

Period of future deposits and compounding: Monthly

Deposits on the first of period: annuity due

Monthly Payment:64.68

Fully Funded

This is an old definition with a simple formula. Take the present replacement value ‘times’ the age of the component ‘divided by’. the useful life.

Fully Funded = present value * age / useful life.

As you can see this is just an approximation of required funds when interest on reserves and inflation of the component, (future cost), should be considered. There are more complicated formulas that take inflation and interest into account but this is done only to get closer to a true annuity calculation.

Distribution of funds

At the beginning of a study there is usually money on deposit. So just as in the simple case above, needed contributions should take into account money already available for expenses. So these funds are distributed among the components at the start of calculations. First is to distribute starting with the earliest replacements the fully funded amount. If there are funds left after going through the components next is to distribute to the present cost of replacement. If funds are still available after this second pass, next is to distribute to twice the cost of components that will be replace in the first years. Any funds left are considered excess funds.

Now a calculation of required contribution can be done for the components. This snip from a test report and reflects the payment example above.

Also shown are the interest earned in the first month and a sum called ‘Reserve Allocation’.

These numbers are summed and presented in the detail summary as ‘Total of All Assets’.

Contingency

An association may decide to keep a percentage of Component Method funds aside. This contingency is taken from the deposited funds before distribution is done. After the required contribution to funds is calculated it is increased by this percentage in each year of the projection.

CFM Velocity

This is provided so the preparer can modify the funding of components to create a pleasing look to the projection. Here is a one component projection with only inflation set at 3%

The calculation for the contribution is annuity due on future cost while the calculation for fully funded is based on the current cost in each year.